Looking for the Bottom Line (by Ben Ford)

August 8, 2015February 8, 2018

Killing the Golden Goose

Paul Krugman , the Nobel laureate in economics that writes for the New York Times, has weighed in on Pueto Rico’s debt plight and delivered a verdict. The island is no longer economically competitive, so don’t make things worse by demanding austerity or allowing vulture capitalists to seize assets on the cheap.

There is a certain cold logic to this viewpoint. Krugman notes that the favorable tax treatment for manufacturers that drove much of the island’s prosperity in the latter half of the 20th century expired in 2006. Even if it hadn’t, the growth of manufacturing in global locales that have access to a much cheaper pool of labor than that available on Puerto Rico would have brought an end in any case. With the end of prosperity the island has suffered from mass migration to the mainland U.S., shrinking the tax base that was critically needed to sustain the huge debt successive governments had taken on to pay for deficit spending.

The gruesome total after decades of irresponsible spending and poor tax policy and collection? $72 billion. It is a stupendous number for a small Caribbean island with only three and a half million people on it. It amounts to about $20,500 for every man, woman, and child. Although this only a third of the U.S. per capita debt ($58,500), it is four times as high as any per capita debt load of any U.S. state.

Krugman’s ultimate point was that Puerto Rico’s plight was not like that of Greece ($390 billion in debt for 11 million people) because the island is part of the U.S. fiscal system, which is homogeneous and centrally controlled, unlike that in the European Union. Puerto Rico also benefits from the U.S. social safety net, which it does not have to self-fund.

I saw a different issue in Puerto Rico’s plight. Who were the idiots who bought $72 billion of worthless Commonwealth debt? Sure you could point fingers at the succession of irresponsible governments who used bonds to pay for political promises rather choosing to govern responsibly. But as they say in Wall Street, there needs to be buyers in order to have sellers.

The simple answer is bond funds and pensions. They have a never ending need for tax favored and steady yields with a nominally low risk of capital loss. And for a long time Puerto Rico was a necessary component of every bond portfolio. So bankers were more than happy to package new debt for Puerto Rican governments and quasi-governmental utilities.

There is a certain prevailing logic in Wall Street that no U.S. government institution will be allowed to default on its debt. This has been tested at the municipal level in the last several years with Chapter 9 bankruptcy filings in several U.S. cities, including Detroit. But there is still disbelief that any state will be allowed to go into default, even those states with horrid debt situations like California and Illinois. Puerto Rico falls in that category, so when the current governor of the island allowed the Commonwealth to start missing debt payments, there was a collective gasp among bankers.

For my part, I think financiers have killed the goose that laid the golden eggs. Greed has led to enablement of fiscal irresponsibility. And now it is time to pay. It is time to recognize that all those billions in paper are worthless. Sweep the deck clean, tighten up Commonwealth borrowing rules, and start over. Because without such a move, what future does Puerto Rico have to look forward to?

5/6/2017 update. Puerto Rico filed for quasi-bankruptcy relief this week (the island cannot file Chapter 9 bankruptcy) under a new law intended for U.S. territories. The total bill? $74 billion in debt and $49 billion in unfunded pension obligations. The amounts excluded $9 billion in utility debt for which creditors had voluntarily reached a separate agreement with the Puerto Rican government.

2/7/2018 update. Aurelius Capital Management, who has bought up Puerto Rico’s bonds in a bid for value, has sued to overturn the bankruptcy filing. It appears the firm hopes to get the Obama administration’s oversight board replaced with one named by the Trump administration in a hope for more favorable treatment.